Grillo's corner: The Great Central Bank Roller Coaster, Part II

By
Paul Grillo

Sept. 1, 2012

In my opinion piece earlier this year, we dealt with what we consider the defining trend of our time, debt deleveraging, and its effect on economic activity. We also talked about central bank responses to this phenomenon and how financial markets have been influenced by this whole environment. We now have two important updates to this story, which we outline below.

Deleveraging update

Our original commentary, "The Great Central Bank Roller Coaster," highlighted an April 2012 report from McKinsey & Company that provided a deleveraging report card. The graphic that we showed from their report explained that only three major developed countries had made progress in deleveraging their economies: South Korea, the United States, and Australia.

Rapid growth in debt*

Deleveraging

Sideways

Japan

South Korea

Germany

Spain

United States

Canada

France

Australia

United Kingdom

Italy

*Defined as an increase of 25 percentage points or higher.

Data: McKinsey & Company, accessed in September 2012.

However, the latest flow-of-funds data from the Federal Reserve Bank of St. Louis show that the deleveraging progress made by the U.S. has since stalled. On a nominal basis, progress is virtually nonexistent. The increase in government-related debt has kept the nation near a debt level of 350% compared to gross domestic product (GDP). (Data: Federal Reserve.)

Charts shown are for illustrative purposes only.

The deleveraging progress in the U.S. has stalled as economic conditions have slowed. Data: Federal Reserve, accessed in September 2012.

Other developed nations are having the same issue, as economic weakness has depressed tax receipts. Spending in these nations has not been restrained to avoid bigger deficits. Recent reports show French government debt reaching 89% of GDP, and Italy’s public debt climbing to 124% of GDP. Almost all of the European Union’s 17 countries have deficit issues. As renewed economic weakness has set in, small or negative growth in nominal GDP has made their situations worse. (Data: Organization for Economic Cooperation and Development (OECD).)

The Purchasing Managers’ Index, published by Markit Group, is an indicator of the economic health of the manufacturing sector. Any reading below 50 is considered to indicate contraction within the manufacturing sector. Data: Bloomberg, accessed in September 2012.

Slowing growth in China

As global market participants and government officials watch the economic deterioration in Europe and stubbornly slow growth in the U.S., many investors have also questioned the recent economic vigor of emerging market countries. Brazil and India, for example, have since experienced dramatic declines in economic growth. China was a strong engine of global growth in the years after the global financial crisis, but that is now changing.

The uneven, investment-led boom that characterized the Chinese growth miracle is finally showing cracks. With officials trying to contain a red-hot housing sector, centrally planned constraints against further real estate speculation has spilled over to other sectors, and has exposed weakness. Foreign direct investment had been a huge stimulant to Chinese growth. Foreign investors have begun to doubt that China can deliver adequate risk-adjusted return on capital.

Additionally, the currency of choice for the payment of provincial Chinese megaprojects was land sales. Chinese state operators are having a harder time with this activity as land values have declined. European financing of Chinese projects and trade with China have dramatically declined as well. China, considered by many to be the global engine of growth, is now operating on fewer cylinders and may be experiencing a so-called hard landing.

After reaching approximately 12% in early 2007, and again notching double-digit gains in 2010, economic growth in China has been on a downswing. Industrial production has followed a similar pattern. (Industrial production is an economic report that measures changes in output for the industrial sector of the economy.) Data: Bloomberg, accessed in September 2012.

Easing pain, but the illness remains

As noted in part one of “The Great Central Bank Roller Coaster,” five central banks have already provided significant liquidity to confront the challenges facing their countries (the U.S. Federal Reserve, Bank of Japan, Swiss National Bank, Bank of England, and European Central Bank). As current economic pressures get harder for politicians and populations, we believe it is likely that a growing constituency will call for easy solutions (solutions with less sacrifice and more short-term rewards that prolong necessary fiscal adjustment). In our opinion, they will want some form of asset purchase activity and/or monetization of debt, which many central banks have already done in their efforts to ease their respective countries’ pain.

The issue with asset purchase activity

Asset purchase activity takes investment supply out of the private markets, often times pushing investors into alternative investments. In this way, commodity and equity markets have benefited in recent years when money is moved into those markets. Bond sectors that include high yield and bank loans also have benefited from this activity. When the liquidity effect wears off, however, markets typically reverse course and head lower, leaving many market participants with the feeling that they are on a roller coaster.

The issue with these liquidity programs, in my opinion, is that they have the potential to create more inflation than intended (the commodity surge that took place during the second round of quantitative easing, or QE2, for example). In the current environment, oil and gasoline prices are already close to near-term highs. The push through of higher petroleum prices in the system should force substitution away from other consumer products. Food prices are also high due to drought conditions around the globe. Additional price pressure should come from the liquidity boost and could cause a difficult environment for low-income families.

The asset purchases also tend to divorce risk markets from fundamentals. It has been stated (by Ben Bernanke, in this case) that the current environment of significant global central bank intervention creates an effect of “all corporations having the same CEO.” Company management decisions matter much less than billions of dollars of potential liquidity. Additionally, the moral hazard risk could keep growing as future market downturns will likely be met with calls for a liquidity solution. This action already led to a major mispricing of risk assets going into 2007 and 2008, and finally, in my opinion, led to the global financial crisis.

What calamity could this current intervention lead to? Societies are patiently waiting through these liquidity exercises because they deliver immediate relief, if only temporarily. We do not know the longer-term effects of these actions, but I remain fearful.

Our approach during the roller coaster

Given this new investment landscape, it is often hard to make portfolio decisions as asset prices move sharply back and forth. Compounding this difficulty is a never-ending cadre of “specialists” who provide fundamental reasons for what are, in effect, liquidity-driven moves. What is an investor to do?

We believe investors are best served by sticking to established themes that conform to today’s macroeconomic and investment environment. Within the U.S., these themes include: (1) an improved banking sector (after significant deleveraging and recapitalization), (2) a corporate sector that has (generally successfully) taken steps to address a challenging economic landscape, and (3) U.S. growth that will remain challenged as the country deals with its bloated public-sector debt and promises to retirees (future liabilities).

Moreover, European growth is at significant risk as Europe tackles the dual task of bank and public-sector debt deleveraging. Finally, global growth potential has fallen as China copes with imbalances in the private sector (a superheated real estate sector, and comparatively low domestic demand when compared to internal levels of investment). With this in mind, emerging countries face growth headwinds but, in my opinion, have the fiscal, monetary, and currency reserve “ammunition” to deal with these economic fires.

Across the diversified funds of which I am a part of managing, we have maintained overweights to the corporate sector, but we remain mindful of our European exposures. We have positions in what we consider to be high-quality sovereign investments and emerging market debt (sovereign and corporate exposure). Within our multisector portfolios, we are currently maintaining hedges in case various policy measures prove inadequate. Interest rate sensitivity has not been dampened at this stage because, in our opinion, interest rates should stay far lower than the mainstream media and popular strategist-types project.

The views expressed represent the Manager's assessment of the market environment as of September 2012, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the manager's current views.

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Paul Grillo biography

Paul Grillo, CFA

Paul Grillo is a member of the firm’s taxable fixed income portfolio management team with primary responsibility for portfolio construction and strategic asset allocation. He is also a member of the firm’s asset allocation committee, which is responsible for building and managing multi-asset class portfolios. He joined Delaware Investments in 1992 as a mortgage-backed and asset-backed securities analyst, assuming portfolio management responsibilities in the mid-1990s. Grillo serves as lead portfolio manager for the firm’s Diversified Income products and has been influential in the growth and distribution of the firm’s multisector strategies. Prior to joining Delaware Investments, Grillo was a mortgage strategist and trader at Dreyfus Corporation. He also worked as a mortgage strategist and portfolio manager at Chemical Investment Group and as a financial analyst at Chemical Bank. Grillo holds a bachelor’s degree in business management from North Carolina State University and an MBA with a concentration in finance from Pace University.

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